By :Sanjana Sharma, Student at Madras School of Economics

“On one side is Eugene Fama, a man with absolute faith in financial markets, on other side is Robert Shiller assessing the human biases and claiming that maybe markets are not as efficient”

The Nobel Prize winners of Economics this year made the economic world go abuzz with debates and amusements. Robert Shiller and Eugene Fama had been declared prize winners along with Lars Peter Hansen. On one side is Eugene Fama, a man with absolute faith in the efficiency of the markets, and on the other is Robert Shiller assessing the human biases and claiming that maybe markets are not as efficient.  Their tiff calls for a lot of attention and thus this article is dedicated to presenting both the sides.

Now Shiller’s basic belief is that humans are not rational, we are guided by a lot many more things than just rationality that influence our behavior in the markets; and that points towards behavioral finance, a branch of economics that deals with the human psychology and how it affects our actions and in turn, the market.

Fama has a more assumptive conventional approach; the basic assumption of this University of Chicago professor is that people are rational and that the market prices reflect that. So ‘investor psychology’ has no room in his works or understandings. According to him, there exists rationality behind all market functionings.

Eugene Fama is regarded as the father of Efficient Market Hypothesis. He argues that the past prices, the present scenario, a company’s figures, all of it is reflected in the market prices and to argue that markets are not all-knowing and all-reflecting then the market model of equilibrium could not exist, an idea he underlined in his ”joint hypothesis”. According to him, the market is unbeatable and that’s that. The supposition in this theory is that information is freely available and at low transaction costs.

He argues that stock price movements are like a random walk in the park, unpredictable. But the stock prices are a true depiction of the fact that the markets work.

Of course like any other theory, the EMH has flaws that jump out and have critics questioning. The 1987 crash remains unexplained by the efficient market hypothesis and only figures as an unexplained anomaly that sometimes just occurs. The EMH supporters are criticized for the lack of a defined approach towards such events. An example would be the recent financial crisis, where Fama was quoted as saying that, “That’s where economics breaks down. We don’t know what causes recessions.”

An extension of that attitude assumes that because we can’t predict, whatever information there is, is so easily distributed that it makes sense to invest in index funds rather than stocks. Warren Buffet did the opposite and still managed to beat the market. He kind of disproves the EMH theory just by being rich and well, staying that way.

Now the widely quoted point of contention between the two laureates is the theory of ‘bubbles’. Fama strongly feels that such a market scenario is impossible to predict, he was quoted as saying in an interview,” The word “bubble” drives me nuts, frankly, because I don’t think there’s anything in the statistical evidence that says anybody can reliably predict when prices go down. So if you interpret the word “bubble” to mean I can predict when prices are going to go down, you can’t do it.”

Fama is a skeptic when it comes to bubbles, and he makes a point to make that obvious. A believer in markets, he is more likely to agree that Shiller’s ideas live in a bubble.

Robert Shiller, a Professor and fellow at Yale and a best-selling author. With an article published in American Economic Review, he started doubting and targeting the basis of EMH. The argument he put forward was that the stock markets were just too volatile to be rational. He pointed out that whatever investors do, emotional decisions are also a part of the equation. Being a behavioral economist, he believes that sometimes economics defies logic because the public makes decisions based on ‘irrational behavior’ and that psychology is a major player in such economic situations. Here’s him in an interview talking about irrational behavior in asset pricing: “We’ve learned a lot about asset pricing, but there’s a basic human element in it that is irreducible. So, predicting what asset prices will do is partly similar to trying to predict what one person will do.”

In 1991 came the Shiller-Case price index, the repeated sales house price index which shows that the real estate values stay near their real values, it was further developed by S& P and Fiserv. It was to study the house pricing trends. The index talks about the over-estimation of real estate values by the home owners due to their psychological biases and that comes into effect in the prices. Add inflation to that and thus, stands a booming real estate market in front of you. His bestselling book “Irrational Exuberance”, released during the dotcom hype brought in all the talk surrounding bubbles. His prediction regarding the stock market crash in 2000 had been right. And then again, Shiller predicted a boom in estate market in 2005 (in the second edition of his book) and the world witnessed what came tumbling after. As a solution to the 2007 crisis, Shiller has supported ‘contingent capital’, where a new kind of debt would automatically convert into equity in case of a financial crisis.

He was once quoted as saying,” When I look around, I see a great deal of foolishness, and I can’t believe it’s not important economically.”

Eugene Fama and Robert Shiller have opposing theories, one is a staunch supporter of rationality in finance and that psychological effects are only anomalies and the other says that the psychological factor is one of the main reasons why the economy fluctuates between a boom and a bubble burst. The interesting fact is that two opposing theories exist together and are still being polished with new data and facts as they come, it’s the debate that shall continue and it is these kinds of debates that will make economics a science, nascent in its art.